In an interview to CNBC-TV18, Prof Eswar Prasad of Cornell University and Sanjeev Sanyal of Deutsche Bank decode why did the Chinese stocks fall 30 percent in the past 3 weeks; why did they rise 150 percent in the 12 months to June 2015; why did they rise when the economy itself was slowing year-on-year?
China's is a problem of excess savings. The main issue is how to channelize these savings productively into the economy. On the back of this, Chinese economy would slow but not significantly. Speaking to CNBC-TV18, Prof Eswar Prasad of Cornell University and Sanjeev Sanyal of Deutsche Bank expect China to maintain over 6 percent growth next year. However, Sanyal believes that the economy might slow down to 4 percent or less in next five years.
Prasad says: “If China continues to invest very heavily in industries where it already has a lot of excess capacity and they cannot absorb it domestically, they are going to have to export it and that is not going to be good for the world economy”.
China may stumble on financial sector reforms. Prasad says India is far ahead in terms of technical infrastructure and corporate governance issues related to firms that lists on the stock market. But he is confident that China will successfully manage its banking sector, shadow banking, real economy and real estate problems, despite the slips it could face.
Sanyal is of the view that China will soon evolve from being a factory of the world to one of the biggest investors of the world, he says adding,“you will see Chinese investments in all kinds of, whether it is in the markets or FDI or official flows through AIIB and BRICS bank.”
“However, if the US for whatever reason does not absorb a lot of this capital you will have this problem of excess capital sloshing around in China will now become a global problem of excess capital sloshing around in the world and you will have bubbles in the world as well,” he adds.
Below is the edited transcript of Prof Eswar Prasad and Sanjeev Sanyal's interview with Latha Venkatesh on CNBC-TV18.
Q: Why were Chinese markets rallying when the economy itself was slowing down from 7.5 percent to under 7 percent?
Prasad: It is certainly a little odd that the Chinese stock market, until the recent downturn, seem to be getting increasingly disconnected from the real economy which was not doing so well but there are some good reasons for this which go back first to the lack of alternatives for households and other investors to invest in China. The housing market was one place where a lot of money had gone in from households but the housing market wasn’t doing so well.
Now the problem is that in China, the only other real alternative was bank deposits which don’t pay very good rate of return. So when the housing market started slowing down, a lot of money started moving into the stock market and that fed on itself.
Also, the Chinese government, as part of its programme of capital account opening, has created this programme called the 'stock connect' which allows money to flow more freely from China to Hong Kong and also from Hong Kong to China and there was a sense that that might lead to an increase in stock prices as well.
In addition to all of this, the government has not been too unhappy about the stock market run up because the economy was slowing down quite significantly over the last year or so and the fact that stock prices were rising was a good thing because it helped boost domestic consumption, it provided a way for firms to get more investment at a time when bank credit growth was slowing.
So the government is not entirely free of fault in this because it encouraged this to happen as it served that short-term objectives and that fed into this broader rally because the government was trying to prop-up economy by making money easier to get the increased amount of liquidity in the economy and that in turn ended up fuelling the stock market as well.
It is sort of emblematic of the difficulties that China faces in terms of its financial market development. It is very unbalanced development and you see these pressures building up in different parts of the system. It was the housing market last year, now it is a stock market and we will see this repeatedly in the future as well.
Q: What is your take on the same issue? Why did Chinese investors rush head long into an economy precisely when the economy was distinctly slowing?
Sanyal: They are absolutely related. So you will have to give me a second to explain what is going on. An economy like China like many other Asian high growth economies is driven essentially by a savings investment dynamic. Basically China saves and invests about half of its economy.
Now it is an USD 11 trillion economy so that means every year it needs to find USD 5.5 trillion worth of investments. That is not an easy thing to do because you are dealing with a country, with a brand new infrastructure, overcapacity in virtually every sector so effectively what is happening ultimately is that the investment rate is beginning to slow as inevitably it was going to happen.
The problem is that the savings rate does not fall along with investment rate. This is a rapidly aging society and as you saw in Japan and many other countries, what happens is that the investment rate begins to fall a lot faster. So what you have is a huge amount of excess capital and savings that is sloshing around.
If the world was a perfect place, all of this would transfer directly into the current account and go out. Of course the China's current account is also exploding out but what happens is governments very often under those circumstances find that as there is a rapid decline in investment, they try to use some of these excess savings to try and to boost the economy or at least smoothen out the process by which the slowdown in investment happens and so you get this bottled up savings, which are sloshing around and is causing bubbles.
Q: The Chinese government did a great job of managing economic growth sustaining over 10 percent for nearly two decades. Are they faltering on financial sector reforms? Are they sequencing their reforms wrongly?
Prasad: China faces such a very difficult situation in the sense that it has been trying to shift away from its dependence in investment heavy growth. When an economy is investing nearly half of its output every year, that is not necessarily a bad thing because China does have very large infrastructure investment needs in its interior provinces and this is an economy that still has a physical capital stock relative to output. That is about one sixth that on the US.
The problem is that a lot of this investment is being financed through a banking system that is not doing a good job of intermediating domestic savings and foreign capital coming in into the most productive investments domestically and that is the key issue - the efficiency of investment.
So, China can get a lot more in terms of productive capacity, in terms of output if the financial system were to work better in terms of channelling investment into the right places. They could then bring down the level of investment start having consumption play a much more important role in economic growth and there has been progress in the last couple of years.
The share of consumption relative to GDP which is about one third in China, far lower than any advanced economy or any other emerging market economy is at least not falling any more. It has been falling over the last decade.
But, in the last two or three years it started going up. The share of consumption growth, both private and household consumption, private and government consumption in overall economy growth is now over 50 percent. The share of the service sector in the economy is a little over 50 percent. So, they are beginning to move things in the right direction. The big question is whether it is fast enough and whether, while they undertake these reforms, they can prevent these bubbles from popping up.
And as you have correctly pointed out, we did have problems in the housing market, that seems to be subsiding right now. Now, we have problems arising in the stock market. I suspect they will be able to control this eventually. Next I anticipate that shadow of banking could be a problem as well. But the Chinese government has created enough resources and enough room for itself to be able to deal with these short-term hiccups.
But there is a real risk that they do not use this opportunity in the next couple of years to undertake all the reforms that they plan to undertake, then you could end up in a situation where the economy has too much investment, too much excess capacity in some industries, where they already have excess capacity and then things are going to turn really ugly.
Latha: Your take on the same thing. Would you say that Chinese authorities have got their sequencing badly? Should they have had more robust financial institutions, more capital account liberalisation?
Sanyal: it is difficult under these circumstances because the changes are so fast. So, it is not like the authorities are not aware of what I am describing, but of course, these dynamics are continuously changing. So, it is not easy to blame authorities for the way because you have to take into account the situation abroad and so on. So, it is not like one cannot blame anyone. And it is the case that the authorities understand that they need to begin to open out because in fact, they have been doing quite a lot of it. They are creating all kinds of institutional mechanisms not just for private money to go abroad but also, through official channels.
So, this is the context in which you need to think about the BRICS Bank, the Asian Infrastructure Investment bank (AIIB), they are also creating foreign direct investor (FDI) opportunities whether creating the new silk route. It is not easy to manage this process exactly. So, you will get these dislocations from time to time.
Latha: We understand that the retail investor in China is largely, poorly educated, not even graduates. Will this mean that there are going to be persistent problems for the Chinese securities markets.
Prasad: Certainly, like in any other stock market, there are a lot of speculative traders in China. But, the real concern right now is whether the number of new entrants into the stock market, especially over the last few months are going to make it harder for the authorities to let the market correct itself.
These new investors who have got in, have put down a significant amount of their savings in the stock market and certainly there is going to be a fair bit of grumbling, a fair bit of pain. So, the big question is whether the authorities are going to respond to that by saying that we are going to protect you small stock investors and there is a danger to that of course because that creates moral hazard in the future. The government will be expected to stop in every time there is volatility.
So, the government is managing this very high-wire balancing act. They do want to let market forces play out even if that means more stock market volatility, but at the same time, they do not want it to erupt into social instability which could in turn affect their ability to undertake economic reforms and so far the Chinese government has been slightly ham-handed in terms of first allowing the stock market to boom as it did and now taking these very stringent measures to try to prop it up and frankly being very interventionist.
But, they will begin to back off once the stock market stabilises or at least the rate of decline is no longer as fast. And then we could see a slightly greater decline in stock prices which I do not think is going to hurt the Chinese economy very much in the long run.
Latha: What about the economy? What is your trajectory of the Chinese economic growth? How much does it slow, say next year and the year after?
Prasad: Over the next two years, the Chinese government can easily achieve growth around its target rate of seven percent. The big question in China always is not whether they will get the growth but how they get it. If the economy starts slowing down, if the stock market turmoil has an effect on consumer confidence in particular and hurts consumption growth then the government may go back to its old playbook, the one they used during the global financial crisis in 2008-2009 where they expanded bank credit very significantly and had a big investment boom that kept the economy going.
They can do that right now but the risks are going to be very great because first of all, monetary policy is not likely to have as much traction in terms of boosting growth and second it is going to create even more risks for the short-term.
So, my sense is that the next couple of years are crucial, not because they are likely to miss their growth targets, but if they achieve their growth targets by going back to a credit financed investment boom and if that causes them to roll back the key reforms that they have started putting into place especially the financial market reforms, then there are going to be very adverse implications both for the Chinese economy and in some sense through spill-over effects on the world economy over the medium-term. Because if China continues to invest very heavily in industries where it already has a lot of excess capacity and they cannot absorb it domestically, they are going to have to export it and that is not going to be good for the world economy.
Q: What is your estimate of the Chinese growth in the next two years?
Sanyal: If you are taking a 5-10 year horizon you will see a lot slower growth. The exact trajectory will depend on how this is managed. If you are looking at a 5-10 year horizon why not 4 years or 3 years? This is a country with a shrinking population.
So, even with low growth rates the per capita income growth rate will still be pretty high and China is not a very poor country, it is a middle income country and if you have GDP growth of 3 percent with shrinking population you can have 4.5-5 percent per capita income growth in the 5-10 year horizon which will not be bad.
The point I am making is it is difficult to put exact numbers to these things but i am just trying to get people to understand the scale of magnitude. This is not about small changes, this is a structural shift in the growth trajectory.
Q: You mean the GDP growth can go even to 5 percent odd next year?
Sanyal: I would be surprised if it is allowed to go below 6 percent. Every year you can see a half a percentage point or even more falling off and this is a structural thing. So, even if the world global cycle picks up this number could continue to fall.
Q: Let us understand China from an India view point. India may not have managed its growth but it has an interest rate market. An interest rate set by banks and borrowers. India has a better FX market. Do you think India has got the financial sector reforms a little better than China has?
Prasad: India certainly has a lot of challenges in the financial sector front but relatively speaking certainly India is doing somewhat better than China. We are somewhat further ahead in terms of banking system reforms, we are further ahead in terms of technical infrastructure and the corporate governance issues related to firms that list on the stock market. However this is not to say that India doesn't have enormous problems.
The fact that non-performing loans are big drag on the Indian banking system which is not able to support Indian industry very well is certainly a big concern. I don't want to imply that India has got it quite right but certainly India has done somewhat better than China in terms of the broader financial market reforms especially in developing the equity markets.
Both countries suffer from a lack of development of the corporate bond markets which is an important channel for intermediating domestic savings into longer term investment. India in particular given the need for infrastructure investment we certainly need to make progress there. However in the stock market i think India has been able to use foreign investors and the liquidity they provide to generate more depth to those markets.
Certainly it leads to more volatility at some times but overall it has been relatively good for the performance of the stock market and for the stability of the stock market relative to what we see in China.
In terms of banking reforms the fact that the interest rates structure is liberalised is certainly something that China has been looking to but China has also been studying how India has been approaching the difficult issue of how to get the public sector banks to work well. In China the banking system is largely state owned still.
They have been trying to move to a model of corporatisation of the banks where they start hardening the budget constraints on the banks, try to get them to respond to market forces and also introduce an element of market discipline.
Here again India is a little further ahead but still India has a long way to go. So, financial market reforms are one area where there is a set of common challenges that these two economies face because unless they both get financed right it is going to be very difficult to generate good sustainable growth over the longer term and especially growth where the benefits are spread more evenly across the population.
Q: Your pet theory has been that China from being a factory of the world will become an investor of the world. Can you elucidate this?
Sanyal: If you go back to the 90s when Japan was going through this then you saw this explosion of Japanese investment aboard. We should expect that to happen. Already Chinese investors are a big player in the global economy but people are underestimating the sheer scale of what this could be.
I have written about this saying that we are probably entering an age of Chinese capital. You will see Chinese investments in all kinds of, whether it is in the markets or FDI or official flows through AIIB and BRICS bank.
I think that will be the key determinant of the next round of global expansion and the way the world absorbs this capital will determine how growth takes place in the next round. I think the amount of capital that will come out will be so large that ultimately the world will have to go back to global imbalances with the US perhaps taking on the role again of absorbing a lot of this capital. One hopes that in this next round if it absorbs this capital it will deploy it more efficiently instead of putting it into McMansions and consuming it they will upgrade their infrastructure which is in appalling state.
So, I hope that that happens. However if the US for whatever reason does not absorb a lot of this capital you will have this problem of excess capital sloshing around in China will now become a global problem of excess capital sloshing around in the world and you will have bubbles in the world as well.
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